A 1031 Exchange is a way to defer tax liability on income from the sale of real estate, if you intend to reinvest the income in another real estate purchase within a specified amount of time. The use of the word ‘exchange’ is probably a little confusing, because it’s not a transaction where you trade your property for somebody else’s.
Following the rules and procedures established by the IRS Section 1031 means any gains you make on the sale of the original property are not subject to immediate taxation as capital gains. This is because selling your existing property (known as the “relinquished property”) and acquiring a new property (known as the “replacement property”) is considered an exchange.
You can defer these taxes as long as you continue to exchange every time you sell the property in the future. Specifically, the taxes we are talking about are capital gains tax and “recapture” of any previously taken depreciation.
In order to capture all the tax benefits of your real estate transaction when engaging in an exchange, you need to follow the proper procedure, which includes:
There are other types of exchanges, including reverse exchanges, improvement exchanges, and personal property exchanges. It’s important to work with an experienced QI so the transactions are executed smoothly and you are able to realize all the tax benefits of the transaction.
If you’re selling your property at a loss, a 1031 exchange would not be the right option for you, since there are no profits to protect; but if you are selling your property for a price greater than when you acquired it, a 1031 exchange can save you the tax you would normally have to pay on the gain. This can add up to substantial savings!
Since reinvesting the income you earn on a real estate sale is good for the economy, the government (See IRS Code on 1031 Exchanges) has allowed this tax saving procedure as an incentive for you to reinvest those proceeds immediately.
Depreciation does not apply when you’re selling land. Depreciation is an IRS sanctioned write-off (See IRS Publication on Depreciation), or deduction from your annual income, tied to the total value of your real estate, minus the value of the land under it. It is the government’s way of acknowledging that your building is deteriorating over time through normal wear and tear.
For example: You buy a rental home for $100,000 (See IRS Publication on Rental Property Depreciation). It is determined that the land value under the home is $20,000. You can start depreciating the $80,000 on you tax return a little bit each year over the next 27½ years (yes, that is a strange number—don’t ask me how they came up with it).
Purchase Price – Land Value = Building Value
$100,000 – $20,000 = $80,000
Building Value divided by 27 ½ = Annual depreciation deduction from income
$80,000 ÷ 27 ½ = $2,909/year deduction
You now deduct $2,909/year from your taxable income. Fast-forward 10 years, and you have deducted a total of $29,090 from your taxable income over this period. Now you sell your property for $150,000. If you don’t do a 1031 exchange (what were you thinking?), not only will you pay capital gains tax on the gain, you will also have to pay tax (recapture) on all of the depreciation you have taken over the last 10 years.
In order to have a legitimate exchange, the law requires that an independent third party act as the facilitator. Also called a Qualified Intermediary, the facilitator:
Now that you know more about the exchange process, let’s start working. Contact us and we’ll be happy to assist you in every way we can.